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The rapid growth of Internet companies has changed the world economy. Increasingly, value is being created, not through the manufacture and sale of physical products (although manufacturing competitiveness is still vital to a healthy economy), but through the transfer of digital information, much of it across borders. This change has delivered significant benefits to people everywhere. It has also placed strains on national and international institutions built around manufacturing and high information barriers. Some countries, especially in Europe, have lately pushed for unilateral changes that would advantage them at the expense of others, mainly the United States. These efforts should be resisted.
One of the largest strains has been on the taxation of international transactions. Corporate taxation is an extremely difficult subject. This is largely because international business has grown more important and complex over time. The current system is based on literally hundreds of international and bilateral treaties to allocate profits among jurisdictions, so all international profits are taxed once and only once. But the modern economy challenges this framework.
Cross-border digital transactions make the problem even more complicated. If a Google subsidiary in one country agrees with a firm in another country to show ads to users in a third country, where should any profits be taxed? Corporate taxation is built on the concept of a physical presence or nexus. Countries can only tax companies that have a sufficient nexus in their jurisdiction. However, the Internet allows companies to have a significant virtual presence involving lots of users, advertising, and sales but no physical presence.
Virtually everyone agrees that international taxation needs significant reform and everyone agrees that corporations should pay their fair share of taxes. The challenge comes over which nations get to claim those taxes. The United States took a big step last year when lowered its corporate tax rate and reduced its application to profits earned overseas. More significant, the Organization for Economic Cooperation and Development is in the midst of a major effort on Baseline Erosion and Profit Shifting (BEPS). It issued an interim report last March on the tax challenges arising from digitization. The report acknowledged several legitimate issues of concern and committed the members to a two-year effort at developing a consensus on these issues, including the concept of nexus and the allocation of profits. This commitment was affirmed at last week’s G20 meeting of finance ministers.
Unfortunately, several European countries have announced a desire to impose a unilateral tax on the largest Internet companies. As outlined in a European Commission report, also issued last March, countries would impose a 3 percent tax on the sale of any collected user data, Internet advertising, and goods or services exchanged over an Internet platform. The tax would apply when a device or user in the European Union viewed an ad, accessed a platform, or generated data. The tax would only be applied to the largest Internet companies. The proposal would also loosen the nexus rules for creating a taxable presence, which would apply to all countries, not just the largest Internet firms
The United States should vigorously oppose this effort, viewing it as mercantilist in nature. It is highly unusual to implement a specific tax on only one type of firm, especially one not connected to profits. Second, it violates the consensus principle for forming international relations. Nations should not implement unilateral changes to agreed-upon rules, whether they deal with trade, taxation, or other subjects. Third, because most of these companies are American, these changes would impose a large loss, not just on U.S. firms, but U.S. taxpayers as well. The latter would suffer to the extent that firms could deduct the foreign tax against their U.S. tax. These efforts should be viewed in the context of other actions by the European Commission that retroactively impose multi-billion dollar penalties on U.S. Internet firms, including Apple and Google, for novel interpretations of European law. Because the proposal for taxing Internet transactions requires unanimous consent among EU members, it stands little chance of passage. Ireland, whose economy has benefitted from its low corporate tax rate, and other countries with pro-investment rules will be reluctant to implement such a radical change to current practice.
But even so, it is important that the United States address this challenge head-on. The Internet economy requires new rules in some cases. But these rules need to be carefully considered. In many, perhaps most areas, little regulation is needed. In others, existing laws are adequate. Where changes are needed, policymakers need to ensure that they do not impair the tremendous innovation and value that the Internet has enabled. At the international level governments also need to ensure that new rules stem from the same consensus approach that has resulted in the vital, but under-appreciated, order that underlies our economic prosperity and political cooperation. Leaders on both sides of the Atlantic should build on this platform, not tear it down.